Rethink the Use of Fixed Income in a Defined Benefit Plan

With the closure of the first quarter, we’d like to remind you of a blog post that we first published in early January.  Our thoughts are still relevant, especially given the market action within fixed income during the quarter and what is transpiring in US fixed income today.  The 10-year Treasury has rallied 2% today, and we think that it may continue to move lower.  The following paragraphs are what we originally posted.

What I’d like to highlight today is a new use for a plan’s current fixed income exposure. In day two of the conference, I attended a panel discussion titled, “Opportunities in Fixed Income and Credit Markets”.  The panel was occupied by 4 senior investment pros (plan sponsor, consultant, and investment managers).  They generally discussed the likelihood that interest rates were going to rise (I’m beginning to wonder if there is anyone out their who doesn’t think that rates will rise), and the implications of that movement on traditional fixed income portfolios.  Most of the panelists talked about various sub-sectors (mortgages, asset backs, bank loans, etc) and which ones might hold up better. There was discussion about shortening duration, etc. They also talked about fixed income’s traditional role as an anchor to windward, a risk reducer, and a provider of liquidity.

However, only one individual mentioned taking a step back to truly contemplate the “role” of fixed income.  He didn’t provide any further perspective, which is why I’m addressing the issue here and today.  I believe (as do my partners at KCS) that a plan’s liabilities should be the focal point of any pension discussion.  As such, they need to be the primary objective for the plan, the driver of asset allocation decisions and investment / portfolio structure.  The asset class most similar in characteristic to liabilities is fixed income.  As such, fixed income needs to play a prominent role in a defined benefit plan.

Instead of worrying about the implications from a rising interest rate environment on an LDI strategy that currently consists of long duration corporates, change the emphasis to matching near-term liabilities, by converting your current fixed income portfolio into a Treasury STRIP portfolio that matches cash flows with projected benefits (Beta portfolio).  First, you are improving liquidity.  Second, duration is shortened in an environment that may not be conducive to long bonds.  Third, you are lengthening the investing time horizon for the balance of the corpus, which will allow asset classes / products with a liquidity premium a chance to capture that performance increment (Alpha portfolio). Finally, the funded status and contribution costs should begin to stabilize.  As the Alpha portfolio outperforms liability growth (hopefully), siphon excess profits and extend the beta portfolio.

This is a proactive move to restructure the fixed income portfolio in an environment of uncertainty.

Lastly, I am not of the general school of thought that interest rates are definitely going to rise, and soon.  I believe that we still have slack demand in our economy, brought on by underemployment, which will keep inflation in check and provide room for stable to slightly lower rates.

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